Interesting outcomes from the WAGN tribunal decision

The Australian Competition Tribunal recently published its decision in respect of WA Gas Networks Pty Ltd's (ATCO) review of the ERA's revised access arrangement for the mid‑west and south‑west gas distribution systems.  The Tribunal set aside and remitted to the ERA the following aspects of the decision:

1. the value for gamma;
2. cost of debt; and
3. various other non-WACC issues specific to ATCO. 

ATCO was unsuccessful in its challenge to the MRP and in its argument on the interpretation of Rule 87 of the National Gas Rules. 

Rate of return on capital to be commensurate with prevailing market conditions

• WAGN proposed the use of various pricing models to determine the expected rate of return on equity.  The Tribunal confirmed that the Sharpe-Lintner CAPM model was the most widely used model for estimating the cost of equity and endorsed its use (together with the WACC approach) by the ERA.
• WAGN also argued that the modelling pursuant to rule 87(2) had to be checked against the standard express in rule 87(1) of the NGR, that the rate of return be "commensurate with prevailing conditions in the market for funds and the risks involved in providing reference services".  WAGN argued that the ERA's modelling did not comply with prevailing conditions in the market, and should be somehow adjusted to meet that criteria.
• The Tribunal rejected this submission, finding that rule 87(1) merely describes the objective when determining the rate of return on capital and it is rule 87(2) (which requires the use of "a well accepted financial model, such as the Capital Asset Pricing Model") that provides the guidance as to how that objective is to be achieved.  The Tribunal said that there was nothing in the Rules to suggest that the outcome of the modelling was to be treated as a "starting point" or merely "provisional".
• The Tribunal stressed that the selection of appropriate input parameters into the model is critical to ensuring that the well accepted financial model achieves the objective expressed in rule 87(1).  That is, if the inputs are estimated correctly, the objective of Rule 87(1) should follow. 

Market Risk Premium

• The ERA applied an MRP of 6% based on a review of the Bloomberg data from 1980 to 2010 and findings that volatility in the equity markets had decreased and almost returned to pre-GFC levels and that market conditions had stabilised.  WAGN argued that markets and expectations are still adjusting to the GFC and that a higher MRP was justified (6.5%).
• The Tribunal noted that markets are volatile, but it was still necessary to estimate a robust MRP to represent market conditions in the future, which is inherently an uncertain exercise and is a matter of discretion, not fact.  The Tribunal found that the ERA had considered the relevant material, and that its decision did not lack reason, nor was it capricious or illogical.   
• Critically, the fact that the Tribunal might, in its discretion, reach a different view was insufficient to overturn the decision.  It was not enough for WAGN to persuade the Tribunal that 6.5% was the preferred figure - rather, WAGN needed to demonstrate unreasonableness in the ERA's decision.  As the Tribunal found that the ERA's decision was open on the evidence before it, WAGN had failed to do so.

Debt Risk Premium

• The Tribunal generally endorsed the ERA's bond yield approach for estimating the debt risk premium.  However, the Tribunal found that the ERA erred when it averaged the various estimates for the DRP which its bond yield approach produced in different scenarios, to arrive at a single value for the DRP. 
• The ERA constructed a sample of 17 Australian corporate bonds and then applied four different exclusion criteria to that sample ( including all 17 bonds, excluding all BBB- bonds, excluding bonds with less than a 5 year term and then excluding all BBB- and less than 5 year term bonds). It applied different weightings to the results took a simple average of each of the four scenarios. 
• However, in taking a simple average the 17 firms in the sample were effectively included a total of 44 times in the averaging process with some firms getting four times the weight of others.  The Tribunal found this averaging process to be in error and remitted the estimate of the DRP to the ERA.
• What is unclear is how the ERA will estimate the DRP on the remitter.  There is little guidance in the Tribunal's reasons as to how the ERA should use its bond yield approach to estimate the DRP, although the Tribunal suggests that the sample of 13 bonds which excluded BBB- bonds "appears to offer the best estimate of DRP".
• The ERA's reconsideration may result in a further challenge and the ultimate result will no doubt inform the review of the approach to cost of debt issues.